How to spot if the COVID-19 crisis has left a scar - Capital Economics
UK Economics

How to spot if the COVID-19 crisis has left a scar

UK Economics Update
Written by Thomas Pugh
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Even though we don’t expect there to be much, if any, long-term economic scarring from the COVID-19 crisis, a surge in the number of businesses going insolvent, a jump in the long-term unemployment rate or a sustained sharp drop in the number of businesses being created could all be signs that the COVID-19 wound is starting to scar.

  • Even though we don’t expect there to be much, if any, long-term economic scarring from the COVID-19 crisis, a surge in the number of businesses going insolvent, a jump in the long-term unemployment rate or a sustained sharp drop in the number of businesses being created could all be signs that the COVID-19 wound is starting to scar.
  • We set out our view in a recent UK Focus (see here) that, unlike the financial crisis which shunted the economy onto a permanently lower growth path (see Chart 1), the COVID-19 crisis is unlikely to leave much of a scar on the economy. But it can take years for signs of scarring to become apparent, so this note lays out where any signs of scarring or healing might appear first. There are three main ways in which the crisis could cause long-term economic damage. First, the destruction of the capital stock. Second, a reduction in labour supply. Third, a decline in the efficiency with which the economy utilises both capital and labour.
  • The most obvious place to look for damage to the capital stock is the data on business insolvencies. The government’s ban on some forms of insolvency means that the number of businesses going bust has actually fallen since the start of the crisis. (See Chart 2.) But once the moratorium on insolvencies ends on 31st March and other government support for businesses starts to be withdrawn, the number of insolvencies will surely surge.
  • If many businesses, such as cinemas and airlines, close permanently, there would be a great deal of redundant capital, which could prevent the economy from returning to its previous growth path. Of course, businesses always go bust at a higher rate than normal during and after a recession, so what’s important is how far insolvencies rise compared to the drop in GDP and how long they stay high for. For example, Chart 2 shows that during the financial crisis the number of business insolvencies rose by more than we would have expected given the drop in GDP and it stayed high for four years. This was an early indicator of the economic scarring that we now know occurred during the GFC. Admittedly, financial crises are especially damaging as they limit credit to viable companies. So far, there hasn’t been any sign of a reduction in credit availability, but a rise in credit costs could be another early sign of long-term scarring.
  • Early signs of scarring may also show up as permanently slower growth in business investment if firms want to hold higher levels of precautionary savings or prioritize paying down debt they have built up over the last year. This is consistent with a slower increase in the capital stock. Chart 3 shows that since the start of the pandemic, business investment has been hit much harder than in the past three recessions. We know that there was significant economic scarring during the GFC and on that occasion business investment didn’t get back to its pre-crisis level for five years. So if business investment remains lower than in the years after 2008 this time, that would be a sign of scarring.
  • Another place signs of scarring might show up relatively early is in the labour market. If there is a reduction in the quantity of labour, through people leaving the workforce or even the country, or a drop in the quality of labour, through less training or education, then output could be permanently lower.

Chart 1: Real GDP (£bn)

Chart 2: Business Insolvencies & GDP

Sources: Refinitiv, Capital Economics

Sources: Refinitiv, Insolvency Service

  • There are many ways of measuring slack in the labour market, but one good indicator is the Recruitment Difficulties score from the Bank of England. When the blue line in Chart 4 is high it suggests that firms are finding it difficult to recruit staff. Of course, this ratio always falls during a recession as firms hire less and the pool of unemployed workers rises. So the key point is that if the Recruitment Difficulties score rises more quickly than the unemployment rate falls, as it did in the aftermath of the financial crisis, it could indicate shortages of labour or skills. This is similar to the message that would be sent from an increase in long-term unemployment. Evidence shows that if someone has been out of work for more than six months then their skills start to deteriorate. So far, most unemployed people have been out of work for less than six months. (See Chart 5.) But if the number of people who have been unemployed for longer than a year rises, we would start to become worried about labour market scarring. In other words, the available pool of labour could permanently shrink as the chances of these people ever getting a job decreases.
  • The same effect could come from changes in migration flows. The ONS’s Labour Force Survey found that the number of UK residents born overseas of working age has fallen by 750,000 in the year since Q3 2019. (See here.) Many of these workers may return after the pandemic. But if they don’t, it could leave the workforce about 1.8% smaller than before the crisis.
  • The third place scarring could show up is in the productivity data if the changes to working practices forced by the pandemic mean that businesses are less efficient. However, the official productivity data are published with a long lag. One potential proxy is the number of new firms being created. As new firms tend to be more productive than legacy firms, a higher number of new companies being created could indicate an increase in future productivity. Admittedly, this is not foolproof. A surge in the number of very small companies could increase business numbers without boosting productivity. So far, despite the pandemic, more businesses were created in the second half of 2020 than in the same period in 2019, as shown by the black line being above the grey line in Chart 6. And more businesses were created in January 2021 than in January 2020. But a sharp drop in business creation would probably not bode well for future productivity.
  • Overall, we think the chances of permanent economic scarring from the COVID-19 crisis are reasonably small. But these are some of the early indicators we will be watching to see if COVID-19 will eventually heal cleanly or if it will leave a permanent scar.

Chart 3: Business Investment (Start of Recession = 100)

Chart 4: Recruitment Difficulties & Unemployment Rate

Chart 5: ILO Unemployment Rate by Duration (%)Chart 6: Business Incorporations (000s, NSA)
 Sources: Refinitiv, ONS. BoE

Thomas Pugh, UK Economist, +44 (0)7568 378 042, thomas.pugh@capitaleconomics.com